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How Would Various Fiscal Policies Affect Federal Debt and the Economy?

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Devrim Demirel

on

July 23, 2014

CBO’s report The 2014 Long-Term Budget Outlook focuses on what the federal budget would look like if current laws remained generally unchanged (those projections are called CBO’s “extended baseline”). Under that extended baseline, growing deficits would cause federal debt held by the public to reach 111 percent in 2039, factoring in the harmful effects that large and growing debt would have on the economy, compared with a projected 74 percent at the end of fiscal year 2014. (See Monday’s blog post for more details.) Of course, there is much uncertainty about budget figures projected that far into the future.

Moreover, other tax and spending policies could have very different results. Therefore, CBO also analyzed how the budget and economy would evolve if fiscal policy differed significantly from that inherent in current law. Specifically, CBO examined three scenarios: one that would result in larger deficits and more debt than the amount in the extended baseline and two illustrative scenarios that would result in smaller deficits and lower debt.

How Do Changes in Tax and Spending Policies Affect the Economy?

Although changes in tax and spending policies can affect the economy in many ways, CBO’s analysis focused on four important ones:

Higher debt crowds out investment in capital goods and thereby reduces output relative to what would otherwise occur.

Increased federal investment in education, infrastructure, and research and development helps develop a skilled workforce, encourages innovation, and facilitates commerce, all of which increase output.

In each of those cases, the opposite change in policy has the opposite effect; for example, lower marginal tax rates increase output relative to what would otherwise occur.

What Effects Would Alternative Fiscal Policies Have on Federal Debt and Economy?

In general, federal tax and spending policies have significant effects on the economy, and those economic effects, in turn, affect the budget. By CBO’s estimate, the three alternative sets of fiscal policies it analyzed would result debt held by the public in 2039 ranging from as little as 42 percent of GDP to more than 180 percent of GDP, according to the agency’s central estimates (see the figure below).

Extended Alternative Fiscal Scenario

Under one set of alternative policies—referred to as the extended alternative fiscal scenario—certain policies that are now in place but are scheduled to change under current law would be continued, and some provisions of law that might be difficult to sustain for a long period would be modified. For example, for that scenario, CBO assumed that the automatic spending reductions required by the Budget Control Act would not occur in 2015 or subsequent years, that scheduled cuts in Medicare’s payment rates for physicians would not take effect, and that many expiring tax provisions would be extended. With those changes to current law, deficits excluding interest payments would be about $2 trillion higher over the next decade than in CBO’s baseline; in subsequent years, such deficits would exceed those projected in the extended baseline by rapidly growing amounts.

The harmful effects on the economy from the resulting increase in federal debt would be partly offset by the lower marginal tax rates that would be in place under that scenario. Nevertheless, in the long term, economic output would be lower and interest rates would be higher under that set of policies than under the extended baseline. With those economic changes incorporated, federal debt held by the public would exceed 180 percent of GDP in 2039, CBO projects.

Illustrative Scenario With Deficits Reduced by $2 Trillion Over the Next 10 Years

Under a different scenario, budget deficits would be smaller than those projected under current law: Deficit reduction would be phased in such that deficits excluding interest payments would be a total of $2 trillion lower through 2024 than in CBO’s baseline, and the amount of deficit reduction as a percentage of GDP in 2024 (nearly 1½ percent) would be continued in later years. In that case, output would be higher and interest rates would be lower in the long term than under the extended baseline. Factoring in the effects of those economic changes on the budget, CBO projects that federal debt held by the public would equal about 75 percent of GDP in 2039, close to its percentage in 2013.

Illustrative Scenario With Deficits Reduced by $4 Trillion Over the Next 10 Years

Under yet another scenario, deficit reduction would be phased in such that deficits excluding interest payments would be a total of $4 trillion lower through 2024 than in CBO’s baseline, and the amount of deficit reduction as a percentage of GDP in 2024 (over 2½ percent) would be continued in later years. Under that scenario, CBO projects that federal debt held by the public would fall to 42 percent of GDP in 2039. That percentage would be slightly above the ratio of debt to GDP in 2008 and the average ratio over the past 40 years (both 39 percent). As in the preceding scenario, output would be higher and interest rates would be lower in the long term than under the extended baseline.

Short-Term Economic Effects of the Alternative Fiscal Policies

Such fiscal policies would have differing effects on the economy in the short term as well as in the long term, reflecting the short-term effects of tax and spending policies on the demand for goods and services. The spending increases and tax reductions in the alternative fiscal scenario (relative to what would happen under current law) would increase the demand for goods and services and thereby raise output and employment in the next few years. The deficit reduction under the other scenarios, by contrast, would decrease the demand for goods and services and thus reduce output and employment in the next few years.

Devrim Demirel is an analyst in CBO’s Macroeconomic Analysis Division.